The Extent to Which Valuations Matter Is Highly Counter-Intuitive

Beyond Buy-and-Hold #100

Valuations matter. Everyone gets that. My Buy-and-Hold friends tell me that all the time.

But they don’t change their stock allocations in response to valuation shifts! How can they justify that?

Most people presume that, while valuations matter, they probably don’t matter all that much. They worry that, if they start making allocation shifts, they may make mistakes. They figure that they can count on the market as a whole to keep prices more or less sane and avoid making damaging mistakes by avoiding allocation shifts.

The trouble comes when too many of us adopt that line of thinking. When all investors are counting on all the other investors to keep things from spinning out of control, there are no investors keeping things from spinning out of control.

I want to show you with numbers (and with a colorful graphic) how crazy things can get. Valuations matter a whole big bunch more than most people suspect.

The Investor’s Strategy Tester lets us compare possible long-term results for two possible scenarios. Both of the sets of results shown below assume a portfolio starting value of $200,000 and a 70 percent fixed stock allocation. The first set of results shows the range of possible outcomes produced when the starting-point valuation level is the valuation level that applied in 1982. The second set of results shows the range of possible outcomes when the starting-point valuations level is the valuation level that applied in 2000.

valuation matters
valuation matters
valuation matters table
valuation matters table

Look at the 30-year numbers. The Red Bar for Scenario One (a low starting-point valuation) ends at $1,190,150. That’s the value of the portfolio in the worst possible case, considering every return sequence we have seen in the historical record. The Red Bar for Scenario Two (a high starting-point valuation) is $560,680. That’s less than half. In a worst-case scenario, your $200,000 will at the end of 30 years be worth more than double if valuations were low at the start of the 30-year time-period.

It’s just the opposite with best-case scenarios, of course. The best-case numbers are $2,649,295 and $1,199,156. Again, the ending portfolio value is less than half in the case in which the starting-point valuation level was high.

And the story is the same at all of the five-year marks. At five years out, the effect is not quite as huge (remember, short-term timing never works). But at 10 years out through 20 years out, it is. At 25 years out, the distance between the two sets of color bars diminishes a small bit and, at 30 years out, it diminishes some more. That’s because, after the passage of that amount of time, the market has been able to recover from the horrible years that always follow a huge bull and build steam for creation of the next bull.

If there were a way to avoid bull markets, I say we should do that.

Actually, there is. The way to avoid bull markets is to teach all investors about the effects of valuations on returns. We all want to invest effectively. Once we all know the realities, we all will be unwilling to go with high stock allocations at times of high valuations. So long as that is the case, a bull can never get too crazy.

Don’t ever get into the habit of thinking that other investors will take care of watching valuations for you. Only You Can Prevent Forest Fires! And Only You Can Prevent Runaway Bulls!

Rob Bennett views his website as an ongoing financial education project. His bio is here. For background on the Big Fail of Buy-and-Hold and on the need to move to Valuation-Informed Indexing, please check out the “About” page at the “A Rich Life” blog.

( Photo from Flickr by Helico )

One Response to The Extent to Which Valuations Matter Is Highly Counter-Intuitive

  1. Rob, if only more investors understood this, it would go such a long way to improving lifetime returns. But the problem is just that – so few investors understand it, nor do they have the tools or resources to measure it (well, they are out there, they just don’t know they exist).

    Even people in our profession don’t get it. Buy and hold under any and all circumstances, you can’t beat “the market”, etc. Sometimes the answer is to not participate in THAT market at THAT point in time.

    Great article.

Leave a reply